Balance sheet Risk.
Balance sheet of a bank carries many risks and one of the major risks not discussed or figuring in the regulatory and supervisory system presently in vogue is the total disconnect between equity or pure capital and intangibles expanded in the form of toxic assets. There does not exist an ideal or acceptable ratio between equity and intangibles. The formation of intangibles particularly in the form of exotic products unfortunately in the garb of better risk management brings in more hidden risks in balance sheet without being managed and without adequate coverage and accountability.
Initial Capital of a bank is generally decided based on ownership and area of operation. Capital is the base based on which business expansion generally takes place, but banks enjoy a special status and are allowed to expand their business without any linkage to the initial capital . They derive business through raising of deposits and creating advances out of such deposits and because of this they are known as derivative institutions. This exclusive privilege of banks to raise deposits repayable on demand and creation of advances out of deposit funds freely allows them to intermediate between savers and borrowers in an economy and they have over a period achieved the status as major intermediaries enjoying the confidence of public and authorities as well. They have graduated themselves as providers of the support system for economic development and occupy a very key and sensitive position interlinking various markets within and outside economies of different countries. It is important to note that under liberalization and economic integration, forms of banking have undergone sea changes and many innovative products have been introduced to meet the demands of fast changing dynamics of the economy.
Maintenance of adequate capital on a continuous basis is an exercise by itself and expansion of business operations is dependent on the extent of capital adequacy position. Banks maintain capital as per basel i and basel ii guidelines depending on their risk perception, risk formation, risk assessment and management capabilities. Expectation is that capital as per Basel II will enable banks to cover risks of exposure in terms of advances and other balance sheet and off balance sheet items in a more meaningful manner factoring there in all market realities and fluctuations. Greater transparency of risk management will be the end result.
Although the initial capital gets increased over a period with retention of profits, it is a matter of serious concern that the size of equity or Pure Capital excluding the retained portion of profit and reserves and surpluses ie only capital contribution by promoters of any bank compared to its total balance sheet size is literally not significant. The position is still worse when this capital is linked to off balance sheet figures which have a direct bearing on balance sheet figures. Pure Capital as a percentage of balance sheet and off balance sheet figures is something negligible and this should be construed as a major risk investors have to worry about. Financial stability in any economy is the major casualty in the absence of adequate pure capital in Financial institutions and banks. In these days of close integration of different economies financial stability is sine qua non and instability through weak banks is something undesirable and totally unacceptable . The present financial crisis the world is experiencing is on account of inadequate pure capital. The capital adequacy ratio presently in vogue based on either BaseI or Basel II requirements ie taking into consideration the reserves and surpluses as part of capital is therefore inadequate and to that extent risk management through capital adequacy ratio cannot said to be reliable /acceptable in the interest of strong banking for economy and financial stability. This has been more than proved in the financial melt down and failure of many banks the world over. Re capitalization of banks is one of the solutions suggested and implemented. Bringing in the concept of only Pure capital ratio to intangibles, total balance sheet, off balance sheet and balance sheet plus off balance sheet items will prove to be a better approach with more accountability, commitment and involvement on the part of both management and regulator. This should be in addition to the present system of arriving at the capital adequacy to risk weighted assets ratio. Expansion of balance sheet and off balance sheet without relating to pure capital ( ie. excluding reserves and surpluses )can only lead to disaster over a period of time and owner stakeholders in particular are allowed to escape from their responsibility. Reserves and surpluses which get added to capital to arrive at the prescribed capital adequacy ratio, come out of accounting practices followed and the authenticity of these figures is subjected to so many ifs and buts . These reserves and surpluses include high profits earned from toxic assets and may carry hidden risk of additional provisions to be provided for bad debts. In the absence of acceptance of international accounting standards uniformly through out the world and implementation of corporate Governance standards in letter and spirit the figures reported under capital ,reserves and surpluses cannot and should not be taken at face value. Further, the Competence of top management, executive level management, genuineness and effectiveness of auditing and accounting practices in vogue , integrity of data collection, analysis and interpretation of data, reporting of information and transparency standards adopted, effectiveness of regulatory requirements and supervisory and follow-up methods vary from country to country and bank to bank and the figures of reserves and surpluses which are in a way derived have to be discounted and should not be linked to leveraging business too much. In the present system of leveraging business without having any link to pure capital, there is a disconnect between owners whether it is government, public or private and top management. In other words, involvement commitment and accountability which are the basic ingredients of ownership management are virtually missing in the present system of capital adequacy ratio.
It is advisable to bring in additional contribution of pure capital as and when balance sheet size and off balance sheet size crosses certain limits. There should be clear cut linkage between Pure capital and business expansion particularly in the form of toxic assets. There should also be an acceptable ratio between equity and intangible assets. The present Capital adequacy ratio which includes profit derived from toxic assets linked to the risk assessment based on certain models alone has not proved to be fully successful although the overall efficiency of the banking system has improved. The realizable value of assets and erosion of capital excluding reserves and surpluses if any need to be introduced in the regulatory frame work to strengthen the the banking system.
Dr.T.V.Gopalakrishnan
Initial Capital of a bank is generally decided based on ownership and area of operation. Capital is the base based on which business expansion generally takes place, but banks enjoy a special status and are allowed to expand their business without any linkage to the initial capital . They derive business through raising of deposits and creating advances out of such deposits and because of this they are known as derivative institutions. This exclusive privilege of banks to raise deposits repayable on demand and creation of advances out of deposit funds freely allows them to intermediate between savers and borrowers in an economy and they have over a period achieved the status as major intermediaries enjoying the confidence of public and authorities as well. They have graduated themselves as providers of the support system for economic development and occupy a very key and sensitive position interlinking various markets within and outside economies of different countries. It is important to note that under liberalization and economic integration, forms of banking have undergone sea changes and many innovative products have been introduced to meet the demands of fast changing dynamics of the economy.
Maintenance of adequate capital on a continuous basis is an exercise by itself and expansion of business operations is dependent on the extent of capital adequacy position. Banks maintain capital as per basel i and basel ii guidelines depending on their risk perception, risk formation, risk assessment and management capabilities. Expectation is that capital as per Basel II will enable banks to cover risks of exposure in terms of advances and other balance sheet and off balance sheet items in a more meaningful manner factoring there in all market realities and fluctuations. Greater transparency of risk management will be the end result.
Although the initial capital gets increased over a period with retention of profits, it is a matter of serious concern that the size of equity or Pure Capital excluding the retained portion of profit and reserves and surpluses ie only capital contribution by promoters of any bank compared to its total balance sheet size is literally not significant. The position is still worse when this capital is linked to off balance sheet figures which have a direct bearing on balance sheet figures. Pure Capital as a percentage of balance sheet and off balance sheet figures is something negligible and this should be construed as a major risk investors have to worry about. Financial stability in any economy is the major casualty in the absence of adequate pure capital in Financial institutions and banks. In these days of close integration of different economies financial stability is sine qua non and instability through weak banks is something undesirable and totally unacceptable . The present financial crisis the world is experiencing is on account of inadequate pure capital. The capital adequacy ratio presently in vogue based on either BaseI or Basel II requirements ie taking into consideration the reserves and surpluses as part of capital is therefore inadequate and to that extent risk management through capital adequacy ratio cannot said to be reliable /acceptable in the interest of strong banking for economy and financial stability. This has been more than proved in the financial melt down and failure of many banks the world over. Re capitalization of banks is one of the solutions suggested and implemented. Bringing in the concept of only Pure capital ratio to intangibles, total balance sheet, off balance sheet and balance sheet plus off balance sheet items will prove to be a better approach with more accountability, commitment and involvement on the part of both management and regulator. This should be in addition to the present system of arriving at the capital adequacy to risk weighted assets ratio. Expansion of balance sheet and off balance sheet without relating to pure capital ( ie. excluding reserves and surpluses )can only lead to disaster over a period of time and owner stakeholders in particular are allowed to escape from their responsibility. Reserves and surpluses which get added to capital to arrive at the prescribed capital adequacy ratio, come out of accounting practices followed and the authenticity of these figures is subjected to so many ifs and buts . These reserves and surpluses include high profits earned from toxic assets and may carry hidden risk of additional provisions to be provided for bad debts. In the absence of acceptance of international accounting standards uniformly through out the world and implementation of corporate Governance standards in letter and spirit the figures reported under capital ,reserves and surpluses cannot and should not be taken at face value. Further, the Competence of top management, executive level management, genuineness and effectiveness of auditing and accounting practices in vogue , integrity of data collection, analysis and interpretation of data, reporting of information and transparency standards adopted, effectiveness of regulatory requirements and supervisory and follow-up methods vary from country to country and bank to bank and the figures of reserves and surpluses which are in a way derived have to be discounted and should not be linked to leveraging business too much. In the present system of leveraging business without having any link to pure capital, there is a disconnect between owners whether it is government, public or private and top management. In other words, involvement commitment and accountability which are the basic ingredients of ownership management are virtually missing in the present system of capital adequacy ratio.
It is advisable to bring in additional contribution of pure capital as and when balance sheet size and off balance sheet size crosses certain limits. There should be clear cut linkage between Pure capital and business expansion particularly in the form of toxic assets. There should also be an acceptable ratio between equity and intangible assets. The present Capital adequacy ratio which includes profit derived from toxic assets linked to the risk assessment based on certain models alone has not proved to be fully successful although the overall efficiency of the banking system has improved. The realizable value of assets and erosion of capital excluding reserves and surpluses if any need to be introduced in the regulatory frame work to strengthen the the banking system.
Dr.T.V.Gopalakrishnan
